Coordination failure (economics)
In economics, coordination failure is a concept that can explain recessions through the failure of firms and other price setters to coordinate. In an economic system with multiple equilibria, coordination failure occurs when a group of firms could achieve a more desirable equilibrium but fail to because they do not coordinate their decision making. Coordination failure can result in a self-fulfilling prophecy. For example, if one firm decides a recession is imminent and fires its workers, other firms might lose demand from the lay-offs and respond by firing their own workers leading to a recession at a new equilibrium. Coordination failure can also be associated with sunspot equilibria (where equilibria are the result of variables that do not have any real impact on fundamentals) and animal spirits.
Coordination failure can lead to an underemployment equilibrium. Coordination failure also implies that fiscal policy can mitigate the effects of recessions, or even avoid them entirely, by moving the economy to a higher-output equilibrium.
Models of coordination failure can have multiple equilibria. In this example a representative firm ei makes its output decisions based on the average output of other firms (e*). When the representative firm produces as much as the average firm (ei=e*), the economy is at an equilibrium. The curve represents possible output decisions for the individual firm, and it intersects with the 45 degree line at three points, meaning there are three equilibria. If the firm and society are better off with more output, point B is most desirable. However, the firm's production is determined by what the other firms decide. Ideally, they could all coordinate to produce at the level corresponding with the equilibrium at point B, but, if they fail to coordinate, firms might produce at a less efficient equilibrium.
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